At a recent meeting with a Sydney-based financial adviser client of mine we discussed a recent blog article by our Chief Economist, David Bassanese on Fundamental Indexing. This financial adviser likened Fundamental Indexing (the indexing methodology used by BetaShares’ QOZ and QUS ETFs) to avoiding the Sirens’ song. It only dawned on me later that this might just not be a passing pun.
This reference is from Homer’s Odyssey which describes the journey home of Ulysses (Greek name Odysseus) following the Trojan War. The route of the journey took Ulysses and his men past the island of the Sirens, beautiful creatures whose voices lured many sailors to shipwreck on the rocks. Ulysses made all of his men put wax in their ears to block out the Sirens’ song, but he himself wanted to hear and understand the song, even if it threatened his sanity. To resist the Sirens’ appeal, he had his men bind him to the mast, agree to ignore his orders, and keep their swords drawn on him in case he escaped his bonds.
Financial advisers and investors alike may well be able to draw the parallel between the Sirens’ enchanting voices and the fads, bubbles and shifting expectations of financial markets. And even though Homer wrote the Odyssey sometime between 12 and 8BC, the remedy self-prescribed for Ulysses is as applicable to investors today as it was to Homer back then, and will no doubt continue to be so in the future. Like Homer, investors will be well advised to ignore the “Sirens’ song” that comes from social-media, press, co-workers and many other forms as relates financial markets, which may well distract investors from their natural course – and lead them to financial “shipwreck”.
One potential way to ‘stay the course’ is via Fundamental Indexation strategies, which take a different approach to market capitalisation based strategies.
Market capitalisation indices link the current price of a share with its weight and therefore its importance in the index. Such an approach is based on a premise that markets are perfectly efficient, and that prices will always reflect true valuations. To the extent that markets are not, in fact, efficient, the market capitalisation weighted approach results in potential drawbacks including being influenced by market speculation, which can cause significant mispricing of the shares and hence ‘inappropriate’ weightings. An example of such a time was in the late 1990’s ‘tech boom’ that led investors to hold significant investment weights in shares with little “fundamental relevance” to the economy at the time, akin to being drawn to the bewitching harmonies of the Sirens.
Fundamental Indexing instead constructs an index based on fundamental measures of a company’s size – sales, cashflow, dividends and book value – hence, reducing the effect of market speculation.
Finally, after a few more adventures, and with some help from his friends, Ulysses returned home and the gods granted him a life of peace and a reward for his devotion to his principles. And so the ending for an early ‘risk manager’ was a happy one. It can be happy, too, for those of us who learn from him. As long, of course, as we are prepared to accept a little binding to the mast.